Municipal Bonds – Safe Bet or Risky Proposition?

By: Timothy Guilmette, Spring 2014 Student Intern

rouletteMany long-term investors have some portion of their portfolios allocated to various types of bonds, and traditionally municipal bonds have been considered a relatively safe investment choice. After all, it’s the government we’re talking about. Unfortunately, the recession of the past decade has revealed that not all municipal bonds are created equal. In fact, the SEC has recently stepped up enforcement action against several municipalities around the country for securities violations related to misrepresentations made to investors. This post will provide some basic information on municipal bonds and provide some helpful links for investors who are thinking about investing in municipal bonds.

Municipal Bonds

A municipal bond (or “muni”) is a debt security issued by a state, municipality or county to finance its capital expenditures. They are attractive to many investors because of the favorable tax implications, as they are often not subject to federal taxes. Municipal bonds are issued for a variety of reasons and some common examples include infrastructure improvements, like highway expansions or the construction of new schools.

There are three common types of municipal bonds: general obligation bonds, revenue bonds and conduit bonds. General obligation bonds are debt securities issued under the assumption that a municipality is able to repay its debt obligation through taxation or revenue generated from specific projects. They are backed by the “full faith and credit” of the governmental entity issuing the bond, meaning the credit worthiness of the bond is based on the financial condition of the issuer. Revenue bonds are issued to fund revenue generating projects and are backed by the projects they fund, not the “full faith and credit” of the issuer, so if the bonds are issued to fund a toll road the creditworthiness of the bond is determined by the financial success of the project. Lastly, conduit bonds are issued to lend money to third parties, such as not-for-profit organizations, and the not-for-profit is responsible for making loan payments on the note from the issuer. For more information on municipal bond types and important considerations, see FINRA’s Municipal Bonds—Important Considerations for Individual Investors.

Recent SEC Violations

Investors looking to invest in municipal bonds should not be lured into thinking that they are a safer choice simply because they are issued by a governmental entity. The SEC has brought enforcement actions against several municipalities in the past few years for securities violations relating to municipal bonds.

In 2010, the SEC charged the State of New Jersey with fraudulently misrepresenting material information concerning municipal bonds issued to fund several pension plans. The SEC claimed state employees misrepresented that several state pension funds were adequately funded, when in fact they were not. This misrepresentation impacted investors’ ability to evaluate the state’s ability to repay on the debt and overall financial condition.

In 2013, the SEC charged the City of Miami for similar misrepresentation concerning interfund transfers that were purportedly being used to mask rising deficits. In that instance, the SEC found that the City of Miami shifted money from the City’s Capitol Improvement Fund to its General Fund in order to masks losses in the General Fund. The City’s General Fund was considered a good indicator of the City’s overall financial health, and the misleading statements lead to the investors believing the city was in better financial strength than it actually was.

The State of Illinois was also charged in 2013 with similarly misleading municipal bond investors by selling $2.2 billion worth of municipal bonds and failing to inform investors that the state’s statutory plan grossly underfunded pension obligations and that there were other pension problems that would have indicated the state’s worsening financial health.

These enforcement actions illustrate that investors should carefully evaluate any municipal bond before investing.

Investor Resources

Luckily, there are several resources available to investors looking to invest in municipal bonds. In addition to Municipal Bonds—Important Considerations for Individual Investors, FINRA’s Municipal Bonds: Information Sources At-a-Glance provides key information sources for interested investors. FINRA also has a convenient municipal bond checklist for those looking to diversify with municipal bonds. Additionally, investors should check out the Municipal Securities Rulemaking Board (MSRB) Investor Toolkit for information on rules, understating financial statements and other useful information relating to municipal bonds.

Municipal bonds can be a great way to diversify one’s portfolio, but investors should carefully research the bond issuer, bond type and information disclosures before investing.